Although leveraged buyout (LBO) activity showed signs of recovery in Q3 2020, financing dropped year on year as the supply of new LBO deals seeking capital remained tight.
High yield bond and leveraged loan issuance for LBOs in North America and Western and Southern Europe dropped from US$26.4 billion in Q2 2020 to US$17.7 billion in Q3 2020. Issuance for the first nine months of 2020 was US$77.2 billion—a 32% drop from the US$113.2 billion recorded over the same period in 2019.
The decline was even more pronounced in Asia-Pacific (excl. Japan). High yield bond, leveraged loan and non-leveraged loan issuance for LBOs was down 74%, from US$8.7 billion for the year through the end of Q3 2019 to US$2.3 billion over the corresponding period in 2020. There was no LBO issuance in the region at all in the third quarter of the year.
Weak M&A market weighs on issuance
Despite a strong start to the year for LBO financing activity—including jumbo deals such as the financing package arranged for Advent and Cinven’s purchase of Thyssenkrupp Elevator—the market fizzled as financial sponsors shifted focus to managing portfolios and put new buyout and exit activity on hold due to COVID-19.
Global private equity (PE) deal value, including exits, buyouts and secondary buyouts, fell from US$726 billion over the first nine months of 2019 to US$633.1 billion over the same period in 2020.
This has had knock-on effects for lenders, who still have the appetite to back LBO credits but have less deal flow from which to choose.
As a second wave of COVID-19 takes hold, however, there is some hope that PE firms are returning to dealmaking—global PE deal value more than doubled between Q2 and Q3 2020, from US$122.8 billion in Q2 2020 to US$314 billion.
Buyout managers have adapted to pursuing and executing deals remotely, and the PE industry also entered the crisis with large sums of cash to deploy. According to Bain & Co, the PE industry had US$2.5 trillion in dry powder to invest going into lockdowns, of which US$800 billion was aimed at buyouts. Buyout firms can only delay doing deals for so long, which suggests that the recent recovery in PE deal activity still has room to run. This, in turn, should see opportunities for leveraged finance lenders improve.
A high quality threshold
When opportunities to finance buyout deals have come to market, demand from lenders has been strong.
Lenders are, however, increasingly selective about credit quality and sector. Investors have coalesced around higher-rated credits in preferred industries such as technology and healthcare. This bifurcation, already evident pre-COVID-19, has become even more pronounced during the disruption. Around 90% of US leveraged loan issuance this year, for example, has been for credits rated B or above.
Deals reflecting this trend include the take private of Chinese online classifieds company 58.com by a consortium including Warburg Pincus Asia, General Atlantic Singapore Fund and Ocean Link Partners, which was funded in part with a US$2.5 billion loan.
In the US, Veritas Capital lined up a US$2.4 billion term loan and US$400 million revolving credit facility to finance its acquisition of DXC Technology Corporation, and Francisco Partners raised a US$950 million high yield bond for its acquisition of cloud-computing group LogMeIn.
In Europe, Permira recently secured a €670 million loan to fund its buyout of pharmaceuticals business Neuraxpharm.
Buyout credits that fall into this select bucket have been able to secure financing with relative ease, and to do so on terms very much in line with what was available in the borrower-friendly pre-COVID-19 market. Pricing, however, has widened, even for good credits. European institutional leveraged loan pricing averaged 531 basis points (bps) in Q2 2020, and 461bps in Q3. This compared to 408bps and 381bps over the corresponding quarters in 2019.
Financing doors remain open
Given the demand for yield from investors, financial sponsors continue to look to negotiate greater flexibility around covenants and EBITDA add-backs, including pushing, with some success, for add-backs that allow borrowers to recognize forecasted cost savings and synergies from a deal before they are realized.
Although lenders have been willing to accept similar, or in some cases more, borrower-friendly terms on the whole to what they provided in the borrower-friendly pre-COVID-19 market, certain provisions have received more scrutiny from lenders, in particular those related to unrestricted subsidiaries.
Pre-pandemic, there were instances where borrowers were able to raise additional leverage against assets and intellectual property held outside the credit group, and thus not subject to terms and covenants. This document flexibility was used (or threatened to be used) with more frequency during the pandemic as borrowers looked to gain access to additional capital in a distressed environment. As a result, more lenders have looked to try to include in documentation certain limitations around unrestricted subsidiary flexibility to try to prevent this practice. This has meant that in most cases lenders have resisted allowing increases to, and in a number of cases looked to tighten, unrestricted subsidiary flexibility.
Overall, however, sponsors seeking to finance companies of the requisite quality have found leveraged finance markets are open and capable of financing deals on terms that remain borrower-friendly, although pricing has widened, even for good credits.